There are six primary factors that influence option prices. The minimum factors that must be taken into account in option pricing models as per IFRS 2 are given below:
As per Appendix B of IFRS 2, a list of factors that all option pricing models take into account as a minimum. These include:
- the exercise price of the option
- the life of the option
- the current price of the underlying shares
- the expected volatility of the share price
- the dividends expected on the shares
- the risk-free interest rate for the life of the option.
Appendix B also contains a discussion of the valuation issues in the context of applying options pricing models. The student should refer to the discussion in IFRS 2 Appendix B. In brief, the following important matters are discussed in Appendix B.
Expected volatility in option pricing models as per IFRS 2? – is a measure of the amount by which a price is expected to fluctuate during a period. Volatility is typically expressed in annualized terms, for example, daily or monthly price observations. Often a range of reasonable expectations about future volatility can be determined, and if so, an expected value should be calculated by weighting each amount within the range by its associated probability of occurrence.
Expectations about the future are generally based on experience, modified if the future is reasonably expected to differ from the past. There may be cases where historical patterns may not be the best indicator of reasonable expectations for the future, for instance where a significant business segment has been acquired or disposed of.
Whether dividends should be taken into account depends on the counter-party’s entitlement to those dividends. Generally assumptions about dividends are to be based on publicly available information.
The risk-free interest rate is the implied yield currently available on zero-coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term of the option being valued.